How the Bank of Canada’s key interest rate works, and what it means for mortgages

Eight times a year, the Bank of Canada sets its key interest rate. Leading up to these routine announcements, there’s typically a flurry of commentary as experts weigh in on what it could mean for the Canadian economy if the central bank hikes, cuts or maintains its current rate. Given the housing market is one of the main pillars of the Canadian economy, potential changes to mortgage rates from the big banks are something observers hold a magnifying glass up to when considering the Bank of Canada’s next decision.

So what is the key interest rate, then?

Whenever the Bank of Canada reveals a new key interest rate, what it’s really doing is setting a target for the overnight rate, the interest rate at which banks borrow funds from one another overnight through the Large Value Transfer System, an electronic wire service used by more than a dozen of the country’s biggest financial institutions. Like the word target implies, the Bank of Canada doesn’t impose the exact rate but rather guides it.

Depending on daily client transactions, some banks will find themselves short on cash at a day’s end, which can happen if clients withdraw more money than they deposit in total. Because the Bank of Canada doesn’t allow such shortfalls overnight, some banks will invariably have to either borrow from a competitor — one whose clients’ deposits outweigh their withdrawals that day — or the central bank itself. (Conversely, a bank with surplus funds has to either lend them to another bank, or deposit them with the Bank of Canada.)

Here’s where the Bank of Canada steers the overnight rates banks charge each other. It pays out interest at a rate that’s 25 basis points below the key rate to banks that deposit money with it overnight and charges interest at a rate 25 basis points above it. In doing so, the bank is generally able to keep the bank rates close to the target, which falls in the middle of the band.

As the central bank points out, “Since participants in the payments system know that the Bank of Canada will always lend them money at the rate at the top of the band, and pay interest on deposits at the bottom of the band, there is no reason for them to borrow and lend funds to each other at rates outside the band.”

Why does the Bank of Canada do this?

“The objective of the Bank of Canada’s monetary policy is to keep inflation close to its two per cent inflation-control target, thereby supporting sustainable economic growth,” the central bank tells BuzzBuzzHome News. The key interest rate is no exception.

The Bank of Canada explains the relationship between inflation and the interest rate accordingly: “Take a decline in interest rates, which reduces both the cost of borrowing and the yield on interest-bearing assets, which tends to encourage borrowing and ultimately spending,” it says. “As a result, over time, there is typically a boost to overall demand for goods and services. In contrast, when commercial interest rates rise, the opposite happens.”

The bank adds that when this demand surpasses supply, prices typically increase, and if this begins to happen at a rate above two per cent annually, it can hike rates to push back, cooling activity.

How does this impact mortgages?

Differently, depending on the mortgage type, as CIBC Economist Royce Mendes explains. “The variable mortgage rates are mortgage rates which are reset based on some underlying interest rate — whether it be on government bonds or the Bank of Canada’s key interest rate,” he says.

A cut to the key lending rate, then, means banks spend less on interest when borrowing money through interbank transactions, which gives them the breathing room to offer lower mortgage rates. If one bank does so, competition can spur the others to follow suit.

Fixed-rate mortgages are another story. “If you’re locked in with a fixed rate mortgage rate that you had signed up for, let’s say at the end of 2014, you wouldn’t have been able to take advantage of the recent cuts that the Bank of Canada has made to their key lending rate,” adds Mendes, though he notes being “locked in” also guards against rate hikes. These fixed-rate mortgages are more influenced by government bond yield, as banks use bonds to fund mortgages, Mendes says.